Defense stocks rise on '07 budget

White House asks for $439 billion next year

By

AugustCole

SAN FRANCISCO (MarketWatch) -- Defense stocks traded higher Monday after the White House requested almost $440 billion for the Pentagon's budget next year, a 7% increase that makes it the centerpiece of the $2.77 trillion request sent to Congress.

Among the factors driving the increase are the tempo of operations in Iraq and Afghanistan as well as Defense Secretary Donald Rumsfeld's push to transform the military from its Cold War posture to a more nimble, smaller force able to fight unconventional threats like terrorists and still be prepared for strategic rivals like China.

The defense budget request is also a 48% increase from 2001, and almost 10% higher than 2005. Meanwhile, the U.S. budget deficit will reach a record this year and the White House is proposing paring back spending on Medicare and other government programs in 2007. See full story.

As a portion of U.S. spending on national security, the Pentagon's budget is more than 10 times what the administration has allocated for the Homeland Security Department.

After a $12 billion increase, the Army's piece of the budget totals $112 billion, edging out the Navy at $111 billion. The Air Force budget totals $130 billion.

Last fall, speculation that the defense budget's growth rate would slow sharply checked some of the enthusiasm for the sector. See full story.

But the doom-and-gloom funding scenarios failed to pan out, said John Douglass, president of the Aerospace Industries Association, a trade association that represents many of the biggest contractors. Instead, the 2007 budget largely looks like what President Bush outlined when he submitted 2006's spending plan last year.

"We tried to tell Wall Street the President was going to stay the course, and he has shown that," Douglass said.

The key for defense contractors is the as-expected $157 billion requested for equipment as well as research and development, according to Banc of America Securities analysts.

In Monday trading, the Amex Defense Index
DFX, +0.00%
and the SPADE Defense Index
DXS, +1.07%
both moved higher.

Valuations on defense shares make the stocks cheap, according to Joe Campbell, Lehman Bros. analyst, which could lead to rising stocks in the sector even if the budget increase was as-expected.

"We believe most investment decisions on defense stocks should have a short time horizon -- certainly less than a year -- coupled with cheap prices and bad investor psychology," wrote Campbell.

Shares of Lockheed Martin
LMT, +1.28%
the No. 1 Pentagon contractor, hit $70.20 at one point -- its highest level since June 2002.

Dow component Boeing Co.
BA, -0.47%
which gets more than half of its sales from defense work but has recently been lifted by its booming commercial aerospace operations, also traded higher.

The administration also wants another $70 billion in extra money for 2006, some of which will be spent on military operations and some on training and equipment to beef up local security forces in Iraq and Afghanistan.

For 2007, $50 billion on top of the normal budget request is needed to fund operations, according to the White House request. Details are expected this spring.

That supplemental funding is important for defense firms because it is used to buy equipment used during operations in Iraq, Afghanistan and elsewhere.

"The defense budget continues to grow but at this point, most of the growth is completely dependent on the war-related funding not yet included in the numbers," wrote Lehman's Campbell.

Budget details

The budget continues to reflect the priorities of a Pentagon directed by Secretary Rumsfeld, who also just presided over a second four-year overview of the military's defense plans for the next two decades. See full story.

"I should say that the [Quadrennial Defense Review] and our budget request for 2007 and thereafter shouldn't be measured in terms of programs and winners and losers," Rumsfeld said during a Monday briefing on the budget.

He called the requests and plans "calibrations in direction."

"The budget funds most major programs, rather than making clear choices to boost some and axe others," wrote Lehman's Campbell.

One area the budget targets for reducing is the number of types of engines used on Lockheed Martin's F-35 Joint Strike Fighter, which is being built for use by militaries around the world.

Other cost-cutting changes include a new unmanned aircraft development program and a tanker ship cancellation that will save $4.4 billion during the next five years.

Some $3.7 billion has been set aside for Boeing's Future Combat System, a broad contract that gives the company great authority over its subcontractors tasked to modernize the Army.

Another $5.9 billion is set aside for the Army to buy more armored vehicles, night vision gear and other equipment.

Banc of America's Nick Fothergill noted that the increase in supplemental spending could mean more business for Army contractor General Dynamics, maker of tanks and other armored vehicles.

Impacts on 2006 results

How much is actually added or subtracted from the budget depends on Congress. This year, however, might be different because of upcoming fall elections. Historically, lawmakers have helped boost the defense budget, not cut it back, during those periods, according to Douglass.

The defense industry will be closely watching Congress' next moves, hopeful that lawmakers will leave most of the budget requests intact.

"The Defense Department and all the services faced some very difficult challenges in preparing this budget -- seeking a balance between protecting near-term readiness and meeting long-term procurement needs," said Lockheed Martin spokesman Tom Greer.

"We're confident the Congressional review process, supported by the QDR, will lead to a healthy and full examination of budgetary and economic impacts, strategy, force structure and threats," Greer said.

For Wall Street, which saw last year's financial results in the defense sector increase, attention turns to 2006. For some time, defense companies have telegraphed that revenue growth is expected to slow along with the growth rate of the U.S. defense budget.

Contractors are flush with cash, which they may use to buy companies to help them build their sales, and also to return to shareholders in the form of higher dividends.

"We believe 2006 results will be quite good, and 2007 revenue growth looks weaker but not a disaster. Everything depends on the companies and how they can perform in times of thinner growth and what to do with their money," wrote Lehman's Campbell.

Rumsfeld also pointed out that the budget is less than 4% of U.S. gross domestic product, a smaller percentage than it has been historically. In the 1970s, it was about 10%.

The budget increase also keeps discretionary spending below inflation, according to the White House request.

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